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CPDOs: Where the Creators and Ratings Agencies Went Wrong


Or, free speech aside, you can't yell, "Fire!" in a crowded movie theater.

The structured side of the business has had far more problems. It is here that CPDOs -- synthetic, collateralized debt instruments backed by a debt security -- were created. Called by different name -- Leveraged Super Senior, Super Senior, Sub-Prime, CDO Squared, ABS of ABS, SIVs, etc. -- CPDOs were unleashed on the world. Some of the problems inherent with CPDOs are very technical in nature. The following is my opinion of a few of those issues:
  • So-called "thin" slices have big loss severity if there are defaults, and that was a problem in CDO squared, and in the legendary ABX BBB trades. Pools of BBB all tended to default together, and because each tranche in the underlying deal was thin, if it experienced defaults it was unlikely to recover anything.
  • BBB tranches can exist that never had better returns than the "equity" below them.
  • Liquidity seems to have constantly been overestimated, which was a driving force in SIV's, Leveraged Super Senior, and ultimately played a role in CPDO. This risk, or at least the margin calls associated with it came back to haunt them on the corporate side as it was the downfall of AIG and the monolines.
  • The ratings were used as the sole predictor of default risk and no attempt was made to consider the credit spread. In many cases, a widening credit spread demonstrated a much higher risk -- one that often proved to be the correct indicator, particularly in the short term.
Some things that went wrong were hard to see at the time. For all the complaints about sub-prime, it was hard to find many investors who though housing prices could go south so quickly.

So, in general I'm neither enamored with ratings, nor do I think they are to blame for everything. However, in the case of CPDO, as you will see, I thought, even at the time, that the ratings made no sense and were likely to cause problems.

You Can't Yell Fire In a Crowded Movie Theater
There are limitations of free speech. There are certain things that you cannot say. If you could say whatever you wanted to, there wouldn't be proceedings related to libel and slander. So free speech does have its limits. Before getting into the specifics of why CPDO in particular seemed so bad, there have always been some things that make me question the validity of the free speech argument:
  • The ratings agencies can earn the Nationally Recognized Statistical Rating Organization (NRSRO) designation from the SEC. That seems like it should mean something. The NRSRO designation isn't easy to get: I can't get it, Goldman Sach's research department can't get it, and even Egan Jones [a smaller ratings company than the big three] had some recent troubles with the SEC on parts of their designation.
  • Ratings from NRSRO impact regulatory capital. Banks can choose to use internal models, but the fact that regulators and regulations ranging from NAIC (US Insurance companies) to Basel (for global banks) allow ratings from NRSRO to affect regulatory capital seems also to mean they are accorded a higher standard.
  • Many investments are required to hold assets of a certain rating quality. This is particularly noticeable at the AAA level and the investment grade versus high yield level. Many money market funds and government run investments have looked will only consider investments at or above a certain rating, which they feel demonstrates their prudence.
  • You cannot mislabel products or purposely mislead people. Nutella got in trouble for being a "healthy" choice, in spite of the fact that it was chocolate. They argued over what healthy meant. But in general, people are protected from sellers of a product making unsubstantiated claims in an effort to sell something. You can call something AAA which might fail and suffer no penalty, but if you label a sugar pill as a diet supplement and you can face fines.
  • Then there is product liability. The Saturday Night Live skit about "bag of glass" as a kid's toy is still my favorite. You can't sell shards of broken glass as it's dangerous. So, you can't serve someone coffee that is too hot in case they spill it on their lap, but you can sell a horribly devised investment product that would not have passed back testing?
  • You cannot falsely yell "Fire!" in a crowded movie theater as it serves no public purpose and is dangerous.
Why CPDO Looked Attractive (The Infomercial)

Before going into the problems of CPDO, it is worth looking at why it looked attractive and why it seemed to work. We will look at a simplified version as it explains most of the concepts without losing too much.

The first thing to remember is investment grade Credit Default Swap ("CDS") spreads were about 40 bps for 5-year CDS at the time. So you could earn 0.4% per annum for selling investment grade CDS on average. Bonds traded almost as tightly as the market was doing well. Sub-prime wasn't an issue, AIG was alive and well, and you could borrow as much as you wanted in the repo market to fund bonds. There were banks, and even hedge funds, that ran "basis" books in the billions and even tens of billions of dollars. Credit was cheap.
No positions in stocks mentioned.

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